Today, the market volatility is expected to be very high. In the short term, the greenback may either skyrocket or slump. The direction of its movement will be determined by the results of the negotiations devoted to the US debt

Interrupted USD rally

Last week, the dollar strengthened against a basket of major currencies by 1.4%. This is the best weekly performance of the US currency since September 2022.

The key obstacle for the USD was mounting fears about an impending US default, which could trigger a global recession.

According to US Treasury Secretary Janet Yellen, the US may declare bankruptcy as early as in the first days of June if the issue with the national debt is not resolved.

Last week, US President Joe Biden tried to solve the problem through negotiations with Republicans and Democrats.

However, a compromise was not found. This led to even greater panic in the markets. Investors began to massively sell risky assets in favor of the safe-haven dollar.

At the end of last week, the greenback also received support from the strengthening of hawkish market expectations. Traders' sentiment changed after an unexpected jump in US consumer inflation expectations and quite harsh statements made by the Fed members.

Against this background, investors slightly increased the probability that the Fed will again raise interest rates by 25 basis points next month.

Now, this scenario is estimated at 20%. However, in the middle of last week, the likelihood of an additional round of tightening was only 2%.

The new week began rather briskly for the dollar. On Monday morning, the DXY index reached a 5-week high at 102.75. However, it was unable to consolidate at this peak and continue its upward movement.

As a result, the greenback fell against a basket of major currencies by 0.25%. The EUR/USD pair rose by 0.2% and closed at 1.0874. Meanwhile, GBP/USD jumped by more than 0.6% to 1.2527, which allowed it to recover previous losses.

On Monday, pressure on the dollar was exerted by two factors: an optimistic statement by the US president regarding the public debt crisis and weak US macroeconomic data, which again made investors doubt the hawkish stance of the Fed.

On the eve of a meeting with Congressional leaders scheduled for Tuesday, US President J. Biden expressed confidence that this round of negotiations would bring the long-awaited result in the form of a deal between Republicans and Democrats.

If the leaders of Congress manage to agree and the US debt ceiling is raised, fears of a default will weaken and the markets will finally breathe a sigh of relief. Such a scenario is favorable for risky assets and negative for the dollar.

Also, yesterday, the USD position was significantly shaken by the publication of the NY Empire State Manufacturing Index. In May, the indicator sharply fell from 10.8 to -31.8. This is its worst performance since April 2020.

The fall in the indicator reflects a slowdown in the US economy. Investors fear that the risk of a recession may force the Fed to abandon further tightening and switch to lower interest rates over the next few months.

Two scenarios for the US dollar on May 16

Today, US dollar traders will pay attention to the release of retail sales data for April. Economists forecast the indicator to increase by 0.8% from the previous value of -0.6%.

The retail sales index characterizes the level of consumer spending and demand. Its jump may point to a significant easing of inflationary pressure in the country.

There are concerns that this may serve as one more argument for the Fed in favor of suspending rate hikes and subsequently lowering them.

If the forecasts regarding the growth in US retail sales come true, the dollar risks falling against all the currencies. However, the US dollar may also show a deeper decline today on news about the public debt.

If the US President is right and the months-long dispute around raising the public debt ceiling is finally resolved, this will cause a considerable decline in the US currency. According to the most negative forecasts, the DXY index will crash below the round figure of 102.

However, many analysts consider such an outcome unlikely. The majority of experts do not expect miracles from today's debt talks and lean towards the continuation of the dollar rally in the short term.

Yesterday's comment by the Republican Speaker of the House of Representatives Kevin McCarthy is also supporting such a scenario. The official has stated that at this stage there is no progress in achieving a bipartisan agreement on raising the debt ceiling.

If on Tuesday we do not see really encouraging progress in resolving this issue, investor fears about a default will intensify. This will lead to an even greater weakening of demand for risky assets and an inflow of funds into safe havens. The dollar will become one of the main beneficiaries.

Against this background, the DXY index may demonstrate strong volatility and jump to 103.50/104.00 in the coming days.

At the same time, MUFG's medium-term forecast for the US currency remains negative.

"Once the dust has settled over the US debt ceiling, we expect the USD to resume its decline," the analysts concluded.